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In this note, I focus on the medium-term attractiveness of US financial stocks based on the prospects for the US economy and Federal Reserve (Fed) and congressional policy. Specifically, I see a case for the performance of financial stocks to improve, driven by four forces:
1. Attractive valuations — The long-suffering banking industry continued to struggle in 2020 (Figure 1). Life insurance companies, meanwhile, are at lows last seen during the 1940s, when there was also a zero-rate regime (of course, rates were at zero during the global financial crisis [GFC] but relative performance was somewhat better then). Consumer finance companies are at prior-recession lows (e.g., the GFC and the early 1990s recession) and diversified financials are in range of their prior three bottoms. All of this adds up to attractive valuations across the financial sector.
2. Rising credit quality — Credit quality should get better, as balance sheets have been improving on both the corporate and consumer sides. Consumer balance sheets were strong coming into the recession. Thanks to the help from fiscal authorities, consumer cash flow is strongly positive. On the corporate side, cash flow has recently turned from negative to neutral. It is true that the pandemic has taken out some of the weakest hands in the economy, but as the economy regains momentum, surviving companies should see revenues start to pick up.
3. Better loan growth — I expect loan growth to improve in late 2021, when the lagged impact of tighter credit standards starts to wear off and the economy is on a stronger footing. There has already been some marginal improvement in auto loans (Figure 2), credit cards, and other consumer lending standards. More improvement is likely as the economy gains momentum.
4. A steeper yield curve — I expect the Fed to keep the short rate pinned at zero, allowing the yield curve (Figure 3) to continue to steepen somewhat as nominal growth prospects improve. (A flat or inverted yield curve hurts banks because they borrow money at short-term rates and invest at longer-term rates.) When the yield curve steepens, that should support a market rotation in favor of sectors with lower valuations, including financials.
Ultimately, for those looking out three to five years, the yield curve should steepen more meaningfully as the Fed will at some point cease quantitative easing (QE), which is taking duration out of the market and keeping yields low. While a similar prognosis in the wake of the GFC proved incorrect (as the initial QE was followed by additional rounds), there are two key differences this time. The first is the use of large-scale fiscal policy during this recession, which tends to be more effective for stimulating growth than monetary policy alone. The second key difference is that this recession was induced by the health crisis and the severe lockdowns it entailed. Unlike the pre-GFC period, there were no large excesses in the economy prior to the pandemic. Consequently, I would expect the economy to return more quickly to higher nominal growth in the coming years, once vaccinations are widespread and restrictions have been eased.
Monitoring the “independent” Fed, fiscal policy, and yield-curve implications
There are, of course, risks to this outlook. Consumer finance companies could face rising default risk if unemployment rises. And banks and life insurance companies could go nowhere or stumble if the Fed were to pursue yield-curve control measures to tamp down long-term rates for a more extended period than anticipated. Any new shocks to the economy would mean a longer and more persistent period of accommodative policy.
For now, the Fed seems content to wait for the broad dissemination of the vaccine to ensure that the recovery is on a self-sustaining path. Recent congressional action has assured the Fed that needy companies and consumers have some form of a lifeline over the tough winter months. Expanded unemployment benefits are available up to the middle of March and small companies in vulnerable industries will be offered additional loans through the Paycheck Protection Program.
Going forward, all eyes will be on the Biden administration and its ability to push through further fiscal stimulus. This will be a key factor for the Fed as it charts the path forward for its asset purchase program.
Taking into account the ability of Biden and Treasury Secretary nominee Janet Yellen to forge consensus, it is possible that further spending, in some targeted form, will be passed by Congress in the first quarter. That could motivate the Fed to take on duration risk in order to slow the rise in yields, if it perceives the spending package to be supportive of its policy mandates. Ultimately, though, the rationale for all Fed policies is to ensure that the economy reaches full employment and sustainable nominal growth as quickly as possible.
Given the potential I see for robust growth in 2021 and 2022, it is likely that in the back half of this year the Fed will be very focused on monitoring how quickly the economy reaches a lower level of unemployment and inflation pressures build. Under my base case, both employment and inflation should recover more quickly than they did following the GFC, and I would expect a prudent Fed to eventually taper QE ahead of raising interest rates, while also “welcoming” a degree of overshoot on inflation.
The independence of the Fed in many ways lies in embracing this inflation overshoot and letting the yield curve steepen over time, giving the central bank the space to use the curve as a policy tool again in the future. How quickly the Fed can gain this space depends in part on how much fiscal stimulus is offered. A somewhat constrained Congress implies that yields will rise slowly. The risk for some US equity sectors that have a duration bias would be an overshoot by Congress, resulting in a yield spike that is unchecked by the Fed.
A 1-in-100-year health crisis has forced aggressive action on the fiscal and monetary policy front to help cushion the blow to the US economy. As growth improves to levels that better match the economy’s potential, I think we should see a 1-in-100-year steepening (albeit a gradual one) in the US yield curve, aiding the long-struggling financial sector.